Sunday, April 5, 2015

Avoiding Momentum Head Fakes

Momentum is an extremely powerful investment strategy.  The basic idea is that objects that are in motion tend to stay in motion---when stocks are strong they tend to stay strong, when bonds are strong they tend to stay strong, etc.

Momentum investing is based on individual investor psychology. When an asset class starts to move from a downtrend to an uptrend generally the "smart money" gets in first.  This is followed by the "not as smart, but still pretty smart money", then the "still pretty smart, but not quite as smart money", and so on and so forth until the inexperienced investor gets in somewhere near the top.  This cycle generally plays out long enough for the momentum investor to get in once the uptrend has started, get out once a downtrend is established, and still make a lot of money on the trade.

Hundreds of research papers have been written proving that momentum works across asset classes and across time frames.  However, just like any investment strategy, momentum can cycle in and out of favor.  The worst type of market for a momentum strategy is a choppy one, which can result in a number of momentum head fakes.  In a choppy market an asset class might move up for one period, causing a momentum investor to enter, and then move down the next period, causing the momentum investor to exit with a loss.  Repeat this cycle over a year or so and it can be a pretty frustrating experience for investors as they always seem to be buying high and selling low.

Every investment strategy has an Achilles heal, for buy and hold it is a bear market, for momentum it is a choppy market like the kind we experienced in 2014.  This presents a particular problem for momentum strategies as investors tend to be more forgiving of losses when the market is down, misery loves company.  However, they tend to be less forgiving of losses when the market is going up.  A negative year for a momentum strategy while the overall market is up can cause investors to jump ship and miss out on the future benefits of momentum.

The answer to this problem comes from diversification.  Not diversification by asset class---large cap stocks, small cap stocks, international stocks, value, growth, etc, but diversification by methodology:

Option 1: A Core/Satellite Approach---In Core/Satellite approach the investor would have a fixed core of a portfolio surrounded by a momentum based overlay.  In a choppy market the momentum overlay would still be subjected to momentum head fakes but the fixed core would remain invested.  In a bear market the investor would be exposed to higher drawdowns but the losses would be shifted to a down market which is psychologically more easy to tolerate than losses in an up market.

Option 2: Multiple Momentum Approaches---Many tactical managers try to optimize the one best momentum methodology.  A smarter approach would be to combine multiple, uncorrelated momentum methodologies together.  The idea would be that when one is being subjected to momentum head fakes the others are not.

Just because momentum strategies struggled in 2014 doesn't invalidate their effectiveness.  Every investment strategy has a market environment that it will struggle in and momentum did exactly what it was supposed to do in 2014.  As practitioners we need to constantly innovate to address these issues as much as we can to ensure the best possible investment experience for clients.

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